NEW YORK, July 10 (Reuters) - Middle market buyout loans offer the best hope of boosting low borrowing levels by private equity firms as sponsors battle cash-rich corporate buyers and U.S. regulators' leveraged lending guidance that are restricting the amount of debt that banks can offer.
After a weak second quarter for private equity borrowing, lenders are targeting middle market companies for dealflow, according to industry players. Borrowing by private equity firms of $91.3 billion in the second quarter of 2015 was down 16.3 percent from $109.1 billion a year earlier, according to Thomson Reuters LPC data.
Although U.S. targeted M&A volume hit a record $1 trillion in the first half of 2015, according to Thomson Reuters, most of this activity was due to purchases by investment grade companies rather than private equity borrowing. Cash-rich companies were able to outbid sponsors and were not hampered by banks' inability to underwrite highly leveraged loans.
"It's hard to see it turning around into a good year for sponsor deals," said a senior investment banker. "I think at best it will be a medium year."
Private equity firms are also facing potential headwinds and increased market volatility from macroeconomic events in other parts of the world, as Greece faces a possible exit from the eurozone, Puerto Rico is up against a potential default and China pumps billions of dollars into its ailing stock market, all of which is curbing banks' and investors' risk appetite.
"The market has seen some volatility stemming from Greece, Puerto Rico and China and new issue has slowed significantly," a loan investor said.
Although private equity firms are facing challenging times, middle market lending could be a bright spot due to smaller deal sizes and alternative lenders' growing ability to provide capital.
"Sponsors are going to continue to be challenged," said a lawyer who specializes in buyouts. "Where they'll be able to do better is in the middle market and upper middle market transactions."
The market has seen a steady flow of middle market deals so far this year. Cosmetic company PDC Brands, which is owned by private equity firm Yellow Wood Partners, wrapped up a $250 million loan this week backing a tuck-in acquisition. GE Capital led the loan, which priced at 450bp with a 1 percent floor. GE is also leading a similar $110 million term loan and a $20 million revolving credit which finances the buyout of health information management provider Precyse Solutions LLC by Pamplona Capital Management.
Middle market loans are easier to execute because non-bank lenders are not subject to regulatory constraints and can provide capital on smaller deals, even if they are highly leveraged and exceed regulators' guidelines of six times debt to EBITDA.
"At the relatively high acquisition multiples we're seeing, there seem to be lenders that are willing to go up to maximum leverage," said Tom Hobbis, co-head and managing director of CIT Sponsor Finance. "I think if a sponsor wants to get a (middle market) deal done, it can."
Yield-driven Business Development Companies (BDCs) are looking for deeper, more subordinated pieces of paper. This has benefited private equity firms looking to buy middle market companies allowing deals to be financed with terms large buyouts from traditional banks could not be done at, Hobbis said.
"There's a surplus of capital providers out there, and some of them are pushing the boundaries of the leveraged lending guidelines," said Jeff Kilrea, the other co-head and managing director of CIT Sponsor Finance.
Kilrea said that while BDCs have not been clubbing together to provide standalone financing, they have been joining lenders with higher risk tolerance that are willing to accept lower leverage and lower priced first out positions that offer payment priority in aggressive highly leveraged loans.
In the first quarter, $7.2 billion in additional non-syndicated deals were submitted to LPC's private database, which is rapidly approaching syndicated middle market volume of $10.2 billion in the same period.
Although middle market borrowing trended higher in the second quarter with $11.9 billion of syndicated middle market private equity borrowing showing a 17 percent increase over the first quarter, volume is still 34 percent lower than a year earlier and first half overall middle market loan volume of $65.6 billion is the lowest first half total since 2010.
Bankers are hoping that the middle market deal pipeline will boost volume in the second half of the year, but with uncertainty over Greece, the slumping oil price and chaos in China's stock market, are aware that it may not be easy.
"We're not characterizing the LBO pipeline as strong, but we are characterizing it as improving," the banker said. "It's moving in the right direction." (Editing By Tessa Walsh and Jon Methven)